The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Sunday, January 30, 2011

The January 15, 2011 Economist Magazine championed your humble blogger's call for the creation of the 'Mother of All Databases' for the global financial industry.

The 'Mother of All Databases' would end opacity in the global financial system. It would have current asset-level data for every financial institution, broadly defined, and shadow banking entity, including structured finance securities, on an observable event basis.

What is observable event based reporting? For each individual loan or receivable on a bank balance sheet, it is simply whenever there is a payment, a delinquency, a default, an insolvency filing by the borrower or similar event, it is reported on a borrower privacy protected basis to the market on the day that it occurs. For each security, whether in the trading or investment book, it is simply whenever there is a purchase, sale, a payment, a delinquency, a default, an insolvency filing or similar event involving the security, it is reported to the market on the day that it occurs.

As reported in the Economist Magazine article titled "the great unknown - can policymakers fill the gaps in their knowledge about the financial system": [emphasis added]

IN THE depths of the Great Depression, Presidents Hoover and Roosevelt had to set economic policy on the basis of information that decision-makers today would consider pathetic. ...

The world has since invented a vast array of financial and economic statistics and the processing power to crunch them. Yet policymakers are today in a similar position with regard to the financial system. New “macroprudential” bodies have been tasked with maintaining financial stability, such as the European Systemic Risk Board (which has its inaugural meeting next week) and America’s Financial Stability Oversight Council. But the crisis exposed vast gaps in knowledge. From conduits and subprime-related securities to the regulatory-capital-enhancement swaps written by AIG, there was a bewildering list of financial exotica that played a significant role in the meltdown.

As regular readers of this blog know, FDR did not limit access to information to only policymakers. Instead, he created a financial market system that functioned well for 70+ years based on disclosing information to all market participants.

In this financial market system, FDR laid out a framework (see here, here, here, and here for example) for what the government should and should not do in the financial markets:

Governments should make sure that market participants are provided with useful, relevant information in an appropriate, timely manner.

Governments should not endorse specific investments.

The Economist Magazine article continues with how policymakers would use the information in the 'Mother of All Databases'.

The International Monetary Fund (IMF) and the Financial Stability Board (FSB), a global club of regulators, have picked some priorities. Three things are at the top of the wish-list. First, system-wide measures of borrowing and “maturity mismatch”, where banks use short-term funding to buy long-term assets. As in the past, these were the root causes of the financial crisis. The world’s ten biggest banks more than doubled the size of their balance sheets between 2003 and 2007. As they made loans faster than they gathered customer deposits, banks plugged the gap by short-term borrowing, often from other financial firms. After the collapse of Lehman Brothers in September 2008 many banks faced severe difficulties rolling over this funding.

Maturity mismatch was not a cause of the financial crisis. It was like trees in a forest, fuel when the fire began.

As has been repeatedly said on this blog, the cause of the financial crisis was opacity. Opacity in structured finance securities that made it impossible to value these securities. Opacity in bank balance sheets that made it impossible to determine which banks were solvent and which banks were not.

Opacity is the issue that the 'Mother of all Databases' addresses.

The second priority is data on the links between big banks and other bits of the financial system. It was not just the investment banking giants that had exposures around the world. Many European institutions were up to their necks in securities linked to the American housing market. This suggests that more information is needed on banks’ exposures across borders and the concentration in underlying asset classes.

This is why Jamie Dimon, Gary Cohen and Peter Sands need and want the 'Mother of All Databases' for the global financial industry. They want to have visibility so they and their organizations can see and get out of the way of big dumb banks and other lightly supervised entities before these banks and entities fail.

The final priority is data on the “shadow banking system” which comprises non-bank financial firms that often slip below regulators’ radar. In the run-up to the crisis, regulated banks became too reliant on shadow banks for funding. Off-balance-sheet vehicles were used to create further layers of intermediation, making things even more opaque.

The goal for the 'Mother of All Databases' is to eliminate opacity throughout the global financial system. Therefore, "shadow banking system" also needs to provide data.

For example, structured finance securities need to provide current asset-level information on an observable event basis. Market participants need this data to analyze, value and make portfolio management decisions (buy, hold or sell) based on the price being shown by Wall Street and bring liquidity back to the structured finance market.

The IMF and FSB will report back in June this year. Some progress has been made. The Bank for International Settlements (BIS), a club of central banks, has used its data on international banking to develop a measure of maturity mismatch. But this is restricted to banks, and covers only their international activities and on-balance-sheet positions; and, as the euro-zone crisis has shown, the BIS data can also be difficult to interpret.

To get a better handle on global banks, the FSB has developed a common reporting template, which will identify exposures to different financial sectors and national asset markets. Persuading banks actually to fill it in may be harder: widespread consultation will be needed and there are confidentiality and legal issues to grapple with.

Collecting the data is not difficult if regulators want to do it, the information technology to support the database has existed for over a decade, nor does it take additional legislation. What it takes to create the 'Mother of All Databases' is for either the regulators or industry to step up and do it.

To show their appreciation for all that regulators and the taxpayers have done for them since the beginning of the financial crisis, without being asked by regulators, the leading global financial institutions should voluntarily provide their current asset-level data to the 'Mother of All Databases'.

The shadow banking system poses a thorny problem too. The IMF is trying to measure the problems of sectors where data do not exist or are sparse: for instance, for hedge funds, money-market funds and over-the-counter derivatives. This will require twisting the arms of financial firms that currently do not report data. Until then, the most severe gaps may be in the most leveraged parts of the financial system.

To date, regulators, under significant pressure from industry trade groups, have backed off from asking for data from the shadow banking system.

For example, in May 2009 the European Parliament passed Article 122a as an amendment to the Capital Requirements Directive. Article 122a requires that credit institutions that invest in structured finance securities must know what they own.

The European Banking Authority, formerly the Committee of European Banking Supervisors, was given the task of developing the regulatory guidelines for Article 122a. It issued a request for public comment.

The only response out of 18 responses that was not from a sell-side firm, an industry trade group dominated by the sell-side or a law firm representing the sell-side focused on the need for underlying asset-level data on an observable event basis. It used the Brown Paper Bag Challenge (see here, here and here) to show that the only way an investor can know what they own for a structured finance security is if they have access to the underlying asset-level data on an observable event basis.

In its discussion of responses to its public consultation, the European Banking Authority made no mention of this one response.

Naturally, in setting the regulatory guidelines for implementing Article 122a, the European Banking Authority did not address whether asset-level disclosure should be done on an observable event basis.

Both the Bank of England and the European Central Bank have also looked at requiring asset-level disclosure for structured finance securities. Both of these central banks were concerned with the possibility of losses by the central banks if they accepted structured finance securities onto their balance sheets but were unable to value these securities both prior to their being pledged and while on the central bank balance sheet.

Despite knowing about the Brown Paper Bag Challenge and why these securities could not be value (see here and here), the central banks, with heavy reliance on expert committees dominated by sell-side firms and sell-side dominated industry trade groups, have not made current asset-level disclosure on an observable event basis a requirement for eligibility to be pledged to their balance sheet.

Paul Tucker of the Bank of England worries about the threats to financial stability that are created from outside the regulated sector and wonders whether the “regulatory perimeter” should be widened to encompass such institutions. That would allow regulators to supervise these firms, but would also give policymakers better information.

Even if the regulatory perimeter is not widened, the requirement that these firms provide data should be. The goal is better information that is shared with all market participants. For those institutions outside of the formal regulatory perimeter, market discipline will have to work to reduce their threat to the stability of the financial system.

What you don’t know will hurt you

For all the effort expended on data gaps, the constant evolution and footloose nature of the financial system complicates matters hugely. As bank whizz-kids dream up new products, it will be hard for officials to keep up. Indeed, there is a good case that new financial techniques are created precisely because regulators cannot spot or understand them and therefore do not penalise them for being risky.

Actually, a better case can be made that the whole point of these financial innovations is to create opacity. As Yves Smith observed on Naked Capitalism:

... opacity, leverage, and moral hazard are not accidental byproducts of otherwise salutary innovations; they are the direct intent of the [financial firms'] innovations. No one was at the major capital markets firms was celebrated for creating markets to connect borrowers and savers transparently and with low risk. After all, efficient markets produce minimal profits. They were instead rewarded for making sure no one, the regulators, the press, the community at large, could see and understand what they were doing.

This is why precisely why regulators need to focus on making sure that useful, relevant information is being disclosed in an appropriate, timely manner.

Returning to the Economist Magazine article:

The insurance contracts that made AIG so entwined with the banking system were designed to help banks boost their capital ratios. The bundling of risky loans into complex securities was attractive for many firms precisely because they had low capital charges. Regulators, therefore, are not just in a race to keep pace with finance, they are in a constant battle to outwit it. The hope is that good market intelligence, for example discussions with clued-up investors, can help officials to become more savvy.

As discussed in the FDR Framework, the task regulators have is to constantly evolve the data disclosure requirements so that opacity does not return to the financial system.

Even if a few humans could get their heads around it—a collective nervous breakdown is more likely—they would still have to decide when to act.

In the run-up to the crisis policymakers and supervisors, like most other people, managed to rationalise bad things that were plain for all to see, such as inflated house prices and some banks’ rock-bottom capital levels. As Claudio Borio of the BIS puts it, “The main reason why crises occur is not lack of statistics but the failure to interpret them correctly and to take remedial action.”

The argument misses that under the FDR Framework the data in the database should be available to all market participants and not just policymakers and supervisors.

For example, the Wall Street Journal ran an article on the Bank of England's (BoE) plan to adopt 21st century oversight of financial institutions. This plan places "a greater emphasis on understanding macroeconomic issues and on requiring the banks to disclose more information to the markets." This plan explicitly trades off market discipline for bank examination and requires the creation of the 'Mother of All Databases'.

According to the WSJ article,

[A] top Bank of England official, Andy Haldane, said the new regulator;will curtail the FSA's practice of dispatching dozens of examiners to banks to collect loads of granular information... Mr. Haldane noted that ... they rarely yield much useful information for regulators, who can find themselves overwhelmed by the quantity of data.

Mr. Haldane identified the flaw in the current bank oversight model and the reason that regulators need to have banks disclose more information to the markets.The markets are not overwhelmed by the quantity of data disclosed by financial institutions. There are a number of market participants, including competitors, who are able to and have an incentive to analyze all of the individual asset level data these institutions could provide and turn it into useful information.

This point is very important as it is the key to why the FDR Framework can be successfully updated for the 21st century using existing information technology to create the 'Mother of All Databases'. Since the markets can and have an incentive to turn the disclosed data into useful information, the markets are able to bring discipline to the financial system that the regulators with their resources cannot.

There are no technological hurdles that prevent making this data available. There are no technological hurdles that prevent the market from using this data.

The cost of providing the data is not a hurdle. Particularly when this cost is compared to the trillions of dollars of losses that the global financial system suffered in the credit crisis because the market did not have this data.

What has prevented this data from being made available is the lack of a regulator who would champion this approach or the industry recognizing that it is in its best interest to create the 'Mother of All Databases' itself.

Saturday, January 29, 2011

"An awful lot has changed in the last three years and we should say 'thank you' to the central banks, to the finance ministers, to the regulators because banks are operating in a safer and sounder financial system." - Barclays' CEO Bob Diamond www.reuters.com

The chief executives of banks met at Davos to discuss what has changed regarding regulation, the sovereign crisis and political intervention in the markets. According to a Bloomberg report,

... [Bob] Diamond presented an “industry issue matrix” for discussion among the participants.... The list of issues was visible through a window into the meeting room.

The matrix contained five items for discussion: Interplay and unintended consequences of proposals to regulate institutions; threats of sovereign debt default, fiscal weaknesses and contagion in the euro zone; reactions to policymakers’ increasing propensity to intervene in markets; financial innovation and appropriate institutional structures; and successful business in a low-yield environment.

Their solution to addressing these issues could be summarized as:

"I think we should be aware of keeping market forces intact because they are very important -- that is where supply and demand come together," Josef Ackermann, the chief executive of Deutsche Bank, told Reuters.

"We have to be very careful. Sometimes market movements tend to have excesses but you cannot regulate the excesses because then you are destroying the markets.

"Sometimes markets have an overreaction and some sort of excesses and that requires the discipline of the market participants. But I think we should in all cases keep the markets intact," he said.

The chief executives know that the only way to bring about effective global market discipline is for financial institutions, including hedge funds, to provide market participants with current asset-level data on an observable event basis.

The chief executives know that eliminating opacity will do more to stabilize and restore trust in the financial markets and help to restore growth in the global economy than any amount of policymaker intervention.

The chief executives know that it is their best interest to have markets that function rather than ineffective regulations with their related unintended consequences. Unlike existing regulations, providing borrower privacy protected current asset-level data on an observable event basis can be implemented in an identical manner globally.

The chief executives know that voluntarily providing current asset-level data is the best way to thank governments, regulators and most importantly the taxpayers for all of the assistance they have provided since the beginning of the credit crisis.

... [T]hat much of the new regulation could "stifle growth" and was contradicting governments' fiscal and monetary policies that are attempting to support countries coming out of the recession.

He said that new regulation was important but there was a major risk of over-engineering the solution.

... One bank chief executive said regulation risked killing competition and innovation in the sector. Another leading finance sector figure said no “single human being” could understand all the different regulations around the world and that regulatory arbitrage was an increasing risk.

A third banking leader said the West was in danger of “regulating growth out of existence”. Pointedly, Mr Sands said that China understood the need for well-run and regulated banks to support economic growth.

...On regulation, Mr Sands said: “A lot of it has been irrelevant, much wildly complicated, some harmful.”

He added that increased costs of capital could “stifle growth”.

Companies would find it harder to access capital, he argued.

... Mr Sands said that banks had been singled out when there were other significant players in the financial crisis.

“A flawed diagnosis drives flawed conclusions,” he said.

On the break-up of the universal banking model, being considered by the Independent Commission on Banking (ICB), he said that in a technology age it was impossible to have “frozen boundaries” around banking structures.

The Financial Times reported that Gary Cohen, president of Goldman Sachs, observed about regulation: [emphasis added]

At the annual meeting of the World Economic Forum in Davos, Mr Cohn, Goldman’s president, criticised regulators’ focus on traditional institutions and urged them to look at the effects of new rules on the whole financial system.

“In the next few years, the unregulated sector will grow at an exponential rate,” he said. “Risk is risk. My concern is that ... risk will move from the regulated, more transparent banking sector to a less regulated, more opaque sector.”

People close to the situation said Goldman executives were concerned about the build-up of risk not just among hedge funds but also entities such as the clearing houses set to take over some of the derivatives’ business from banks.

The New York Times reported that Jamie Dimon, the chief executive of JPMorgan Chase, observed: [emphasis added]

But Mr. Dimon broke with some others in the banking industry when he called for rules to make it easier to dissolve sick banks. Mr. Dimon invented an acronym: M.D.B.B.D.B. That stands for “minimally damaging bankruptcy for big dumb banks.”

The big unfinished job in bank regulation is to develop procedures to prevent big, interconnected banks from sowing distress throughout the financial system. But some in the industry have expressed opposition to rules that would identify systemically important banks and subject them to even tougher rules.

“It’s a little bit complicated, but it can be done,” Mr. Dimon said of winding down a failed institution.

Mr. Dimon insisted that he was not against banking regulation, just irrational regulation. He also said it was unfair to criticize banks for trying to block new rules they did not like.

... “It is not clear why some regulators who were there before the crisis should believe they now have all the right solutions,” he said in Davos. “The current regulatory debate is a bit like discussing having better seat belts on planes. It’s hard to argue against, but when the plane crashes, it’s all a bit marginal ... the real focus of regulation should be on making the air traffic control system safe.”

The bottom line to all of these comments is that all of the regulatory efforts since the beginning of the credit crisis do not address what these bankers know to be the real problem that caused the recent financial crisis and, if not addressed, the real problem that will cause the next financial crisis.

The problem that caused the financial crisis was opacity.

First, there was opacity in the structured finance securities that made these securities impossible to value. Second, there was opacity in the current assets on financial institutions balance sheets. This made it impossible to tell which financial institutions were solvent and which were not.

What Jamie Dimon, Gary Cohen and Peter Sands want is to have visibility so they and their organizations can see and get out of the way of big dumb banks and other lightly supervised entities before these banks and entities fail.

As readers of this blog [and Jamie Dimon, Peter Sands and Gary Cohen] know, this can be achieved with a simple regulation that requires all financial institutions and structured finance securities disclose useful, relevant information in an appropriate, timely manner. For financial institutions and structured finance securities this information would be current asset-level data for all assets on the balance sheet on an observable event basis through an independent third party.

This simple regulation modernizes the financial system created in 1933 and embodied in the FDR Framework describing the appropriate involvement of governments in financial markets.

With this disclosure, all market participants can perform their own analysis and valuation of the financial institutions and structured finance securities. With this disclosure, all lenders and investors can know what they own. With this disclosure, credit and equity market analysts and rating services can exert market discipline by linking the value of a bank's securities to its risk. With this disclosure, regulators can piggyback off of market participants in identifying risks that need to be addressed across the global financial system.

Your humble blogger is thrilled to have the support of Jamie Dimon, Peter Sands and Gary Cohen. Without talking to your humble blogger first, they have carried your humble blogger's message to Davos this year on the need for regulation that will end opacity in the global financial system.

Your humble blogger is expecting an invitation to Davos next year as a featured speaker.

Wednesday, January 26, 2011

According to an article on Bloomberg, JP Morgan is refusing to provide the trustee for several RMBS deals with the loan-level data necessary to determine if the loans must be repurchased under the representation and warranty provisions of the deals.

A JPMorgan Chase & Co. unit refused to give mortgage trust investors more than 500,000 loan files that would show them how many of the loans are bad and must be repurchased, a trustee said in a court filing.

A unit of Deutsche Bank AG said it has a right to the files as trustee for the investors. The investors own 99 mortgage- backed-securities trusts that were built on loans made by Washington Mutual Bank before it was seized by regulators and sold to JPMorgan in 2008 for $1.9 billion.

“These access rights are unqualified and have been unequivocally breached by JPMC,” Deutsche Bank said in court papers filed in federal court in Washington on Jan. 14.

Mortgage-bond investors and bond insurers have accused loan sellers like WaMu and JPMorgan or bond underwriters of often misrepresenting the quality of the underlying debt. Those misrepresentations can trigger contractual or legal provisions requiring repurchases, investors claim. So-called mortgage putbacks may cost banks and lenders as much as $90 billion, JPMorgan bond analysts said in October.

... Deutsche Bank National Trust Co.’s suit on behalf of investors against New York-based JPMorgan and the Federal Deposit Insurance Corp. claims the trusts have lost $6 billion to $10 billion in value. WaMu expected some of the loans it put in the trusts to go bad, according to a U.S. Senate investigation cited by Deutsche Bank.

JPMorgan and the FDIC have asked a judge to throw out the case. The Deutsche Bank filing is the trustee’s response to the motion to dismiss the lawsuit.

... Should Deutsche Bank win the case on behalf of the trusts, it would either have a claim against JPMorgan or the FDIC, depending on how the judge rules, Starke said.

In a different lawsuit,

... JPMorgan’s EMC Mortgage said this week that it plans to turn over documents detailing the quality of loans in a mortgage trust managed by San Francisco-based Wells Fargo & Co. in an attempt to resolve a lawsuit.

Wells Fargo sued seeking access to files for more than 2,000 underlying mortgages in the Bear Stearns Mortgage Funding Trust 2007-AR2. The complaint, filed in Delaware Chancery Court, accused EMC of playing “rope a dope” and dragging its feet.

Bottom line: all of this would have been preventable if current loan-level information on an observable event basis had been provided through an independent third party.

Since the beginning of the credit crisis and the Lehman bankruptcy, governments and regulators have been confusing positive bank capital ratios with solvency. Bank capital ratios are a function of accounting. Solvency is a function of the market value of what a bank owns and what it owes. The only time bank capital ratios and solvency overlap is when banks apply mark to market accounting.

A simple example demonstrates this point.

Day 1: Bank balance sheet

Assets - Cash = $100

Liabilities - Bank Deposits = $ 80

Equity - Common Stock = $ 20

The bank has a Tier 1 capital ratio of 20% and is solvent on a mark to market basis.

Day 2: Bank buys security for $100 and announces purchase of this type of security to market
Day 3: Market value for this type of security drops and value of the bank's security drops to $50

What does the bank's balance sheet look like at the end of Day 3? The are two basic ways to account for the bank balance sheet: historic cost or mark to market.

Day 3: Bank balance sheet

Historic CostMark to Market

Assets - Security = $100 $50

Liabilities - Bank Deposits = $ 80 $80

Equity - Common Stock = $ 20 ($30)

Bank Tier 1 Capital Ratio = 20% less than 0

Under historic cost accounting, the bank is well capitalized and has a positive bank capital ratio. Under mark-to-market accounting, the bank is insolvent just like Lehman Brothers was.

Clearly, a bank can be insolvent on a mark to market basis and still have a positive bank capital ratio under historic cost accounting. Since the banking industry primarily uses historic cost accounting, their capital ratios are meaningless as an indicator of solvency.

The previous paragraph makes a very important point.

In the absence of mark to market accounting or the disclosure of asset-level detail so that investors can mark the assets to market for themselves, all discussions of bank capital are meaningless.

If a bank is insolvent on a mark to market basis, it is irrelevant if it is in compliance with Basel III on a historic cost accounting basis. If a bank is insolvent on a mark to market basis, it is irrelevant if it has a high capital ratio on a historic cost accounting basis.

However, this is not the end of the example because it does not address how governments and regulators confuse positive bank capital ratios with solvency.

Day 4: A bank examiner shows up and looks at the bank's financial performance under both historic cost and mark to market accounting.

Now the regulators have a problem. Clearly, regulators are going to want this bank to raise additional equity. However, the regulators know that if investors see the mark to market accounting results, they will not invest unless they are protected from the losses currently on the bank's books. The regulator also knows that if investors do not put money into the bank the government has to put in the capital and this will contribute to a sovereign debt crisis.

If the regulator does not want to protect investors from the losses currently on the bank's books or put up the capital, what does it do? The solution championed by the regulators and the bank is to stop accounting for the bank on a mark to market basis and look to bolster the market's perception of the bank's solvency.

Day 5: Regulator announces that bank has passed a rigorous stress test on its solvency and need a modest amount of additional equity.

Day 6: Bank announces that it is raising capital.

The question for investors is should they invest. The case for investing is the regulator says the bank is solvent. The case against investing is the investor knows the bank has an asset that has declined in value on its balance sheet that could threaten the solvency of the bank.

With this example in mind, let us turn to Spain and the report of its adoption of a policy of having their savings banks, cajas, increase their capital ratios.

Spain will impose a core capital requirement of as much as 10 percent on lenders that don’t have private investors and depend on wholesale funding, Finance Minister Elena Salgado said.

... Listed banks will need to boost their core capital, a measure of financial strength, to the 8 percent level by the end of September, while those that “aren’t listed, that depend on wholesale markets and don’t have private investors,” will have to reach 9 percent to 10 percent, she said in an interview in Madrid with broadcaster TVE today.

Salgado also said the Bank of Spain’s forecast that lenders need additional capital of as much as 20 billion euros ($27 billion) is only an “estimate,” and the figure won’t be written into law. The bill on overhauling the banking system, to be passed next month, will only refer to the “necessary amount,” and the final total “will be that which allows them to reach those capital ratios,” she said.

... Spain said lenders that fail to bolster their capital from private sources will have to seek funds from the bank-rescue facility in return for shares with voting rights. The higher level for unlisted lenders, which includes savings banks, known as cajas, is a further incentive for the regional lenders to seek private shareholders.

How did investors and other market participants react to the estimated size of the capital injections needed to produce higher positive bank capital ratios and the appearance of solvency on a historic cost accounting basis?

Fitch Ratings said ... there’s no “clear stimulus” for private investors to put money into the lenders as the government wants them to. There are still doubts about “the depth of potential asset quality problems,” the company said in an e-mailed statement today.

While more capital for the Spanish banking system is welcome, more stress tests are needed to help investors assess the true value of assets and what the final capital shortfall might be, said Inigo Lecubarri, who helps manage about $200 million at Abaco Financials Fund in London.

“It is a necessary condition to have more capital but another condition is to make sure the assets and liabilities of the industry are adequately priced,” said Lecubarri in a telephone interview. “That’s not happening yet in Spain and it’s another side of the coin that is also important.”

Investors want to see for themselves that the savings banks are solvent when the assets and liabilities are adequately priced (this is the equivalent of marked to market) before they are willing to invest. This is not surprising because otherwise they are buying the losses on the balance sheet of the savings banks.

Your humble blogger only knows of one way to make sure the assets and liabilities of the industry are adequately priced. That way has been discussed many times on this blog and is accomplished through disclosure of asset-level data. This disclosure allows the investors to value the assets and liabilities for themselves and determine if the savings banks are solvent or attractive investment opportunities.

Update
Can banks that have a positive capital ratio on a historic basis, but are insolvent on a mark to market basis make loans?

Yes. Remember that financial institutions can continue to make loans until they are a) closed by regulators or b) market participants come to understand that they are insolvent and effectively close it by engaging in classic run on the bank behavior.

How does mark to market decrease lending capacity?

It does not decrease lending capacity. What mark to market decreases is the capacity for a bank to hold loans on its balance sheet.

Banks are required to hold capital against their assets. The idea being that the capital is there to support any losses that are incurred on its assets. The capital requirement is typically specified as a percentage of the assets. The capacity to hold loans or any other type of asset decreases on a mark to market basis when the market value of a security or loan held on the balance sheet declines. This loss in value reduces the bank's capital that could otherwise be used to support holding a loan on the balance sheet.

During the recent credit crisis, bankers and many regulators argued that mark to market accounting should be discontinued because the market was not properly valuing the structured finance securities they were holding and, as a result, the reduction in each bank's capital base constrained its capacity to make loans while continuing to meet regulatory capital requirements.

Actually, the reduction in each bank's capital base constrained its capacity to hold loans on its balance sheet. Banks were not restricted in the how many loans they could originate. Once they filled up their balance sheet, they would have had to distribute any additional loans they originated. This is something that banks have done for years through loan syndications and later securitizations.

Tuesday, January 25, 2011

Apparently, the bill for the fiscal and monetary policies that have been implemented since the start of the credit crisis is coming due. According a Telegraph report on comments made by Mervyn King of the Bank of England,

Families will see their disposable income eaten up as they “pay the inevitable price” for the financial crisis, Mervyn King warned.

With wages failing to keep pace with rising inflation, workers’ take- home pay will end the year worth the same as in 2005 — the most prolonged fall in living standards for more than 80 years, he claimed.

Please note that Ben Bernanke has said that one of the goals of a zero interest rate policy is to create inflation. While the 'official' statistics do not show it, anyone who has been shopping (food, gas, health care, college tuition or clothing for example) has seen prices increase significantly. According to Shadow Government Statistics, inflation in the US is running at 10%. So it appears that he has been successful.

At the same time, there is downward pressure on wages due to the large number of unemployed workers.

Taken together, it is easy to see why Mervyn King sees a plunge in the standard of living. Unfortunately, this plunge in the standard of living sets up a downward spiral where consumers cut back and industry also cuts back in the face of reduced consumer demand.

Mr King issued the warning in a speech in Newcastle ...

Mr King said he was unable to offer any imminent hope of a rise in interest rates in coming months because of the poor economic outlook. Savers and “those who behaved prudently” would be among the biggest losers in the squeeze, he admitted.

A friend observes these artificially low interest rates and calls them a "tax on the prudent". It is the prudent who cut back on consumption as they realize that the artificially low interest rates require them to save more for retirement. This tax on the prudent is a significant headwind to economic growth that Walter Bagehot advised central banks against.

As observed in a previous post, it is only the prudent who have an ability to expand their consumption. In your humble blogger's opinion, raising interest rates would actually result in the prudent consuming more and getting the economy growing again.

However, raising interest rates is not the tack being taken by either the Fed or the Bank of England.

Disposable household income has been hit by sharp increases in the cost of food, fuel and tax, coupled with restricted wage rises for most workers. Last year, take-home pay fell by about 12 per cent, official figures showed, and the trend was expected to continue in 2011.

The governor warned that the Bank “neither can, nor should try to, prevent the squeeze in living standards”.

He said that the economic figures were a reminder that the recovery will be “choppy”. However, he said the biggest threat facing the Bank’s Monetary Policy Committee, which sets interest rates, was rising inflation.

The Bank is expected to use interest rates to keep inflation below two per cent, but the governor said inflation could rise “to somewhere between four per cent and five per cent over the next few months”.

He claimed that rising inflation had been caused largely by increases in global oil and commodity prices, and tax rises such as the increase in VAT introduced at the beginning of the year, which the Bank was powerless to control.

“In 2011, real wages are likely to be no higher than they were in 2005,” he said. “One has to go back to the 1920s to find a time when real wages fell over a period of six years.

“The squeeze on living standards is the inevitable price to pay for the financial crisis and subsequent rebalancing of the world and UK economies.”

Mr King insisted that the Monetary Policy Committee could not have increased interest rates from their current record low level to tackle the rise in inflation.

“If the MPC had raised the Bank Rate significantly, inflation might well have started to fall back this year, but only because the recovery would have been slower, unemployment higher and average earnings rising even more slowly than now,” he said.

A very clear statement that he does not believe that relieving the tax on the prudent would result in increased demand.

“The erosion of living standards would have been even greater. The idea that the MPC could have preserved living standards, by preventing the rise in inflation without also pushing down earnings growth further, is wishful thinking.”

He added: “Monetary policy cannot be based on wishful thinking. So, unpleasant though it is, the Monetary Policy Committee neither can, nor should try to, prevent the squeeze in living standards, half of which is coming in the form of higher prices and half in earnings rising at a rate lower than normal.”

“The Bank of England cannot prevent the squeeze on real take-home pay that so many families are now beginning to realise is the legacy of the banking crisis and the need to rebalance our economy.”

The comments represented one of the governor’s starkest warnings yet. His claim that the banking crisis was behind the ongoing squeeze on living standards comes at a sensitive time, as banks prepare to announce multi-million pound bonuses for their executives.

Mr King expressed sympathy for savers and highlighted the failure of lenders to pass on cuts in interest rates. “I sympathise completely with savers and those who behaved prudently now find themselves among the biggest losers from this crisis,” he said. “But a return to economic stability from our fragile condition will require careful and well-judged steps looking beyond the next few months.”

Addressing the problems of borrowers, he added: “Households and small businesses with little housing equity may be unable to borrow at all or are able to borrow only in the unsecured market – where rates are much higher than before the crisis.”

Bloomberg reported on potential double standards in RMBS deals for bad mortgages that would be easily prevented with current loan-level data on an observable event basis managed by an independent firm with no conflicts of interest.

The action that gives rise to potential double standards:

JPMorgan Chase & Co. demanded that a lender repurchase bad mortgages even while resisting calls that it buy back the loans from bonds created by Bear Stearns Cos., an insurer said in court papers.

Potential Double Standard 1: Denying a mortgage for repurchase from an RMBS deal while seeking to put back mortgage to lender who sold mortgage.

Naturally, investors and insurers believe that the terms of the deal of the RMBS transaction entitle them to symmetrical treatment: mortgages that are put back to the lender for repurchase should be repurchased from the collateral pool. Ambac filed a suit arguing just this against JPMorgan.

... Bear Stearns sought on March 11, 2008 -- just weeks before the collapsing company agreed to be bought by JPMorgan -- to have a lender buy back mortgages in bonds insured by Syncora Guarantee Inc., according to the filing. Bear Stearns said the mortgages failed to meet promised standards of quality.

At the same time, Bear Stearns was denying demands from Syncora that it repurchase the loans, even though the insurer cited the same flaws, according to the filing. Bear Stearns had bought the loans and packaged them into bonds to sell to investors.

... JPMorgan later maintained “that it is EMC’s position that these breaches materially and adversely affect the value” of the loans, according to the complaint, which cited a June 26, 2008, letter from Alison Malkin, an executive director in JPMorgan’s securities unit, to the lender, a now-closed unit of Capital One Financial Corp.

“Remarkably, Malkin took diametrically opposing positions in repeatedly refusing to comply with all but 4 percent of Syncora’s repurchase demands,” Ambac said in the proposed amended complaint.

... The bank also ignored the findings of mortgage-review firm Clayton Holdings LLC in abandoning mortgage repurchases that Bear Stearns had been considering in early 2008 stemming from a pool of 596 of loans in bonds guaranteed by Ambac, according to the insurer’s amended complaint.

Clayton found that 56 percent of the loans involved “material” breaches of Bear Stearns’s contractual promises, according to the filing, which cited a copy of a November 2007 document from the review firm to the company.

As Malkin overruled Bear Stearns decisions on which mortgages to repurchase to limit JPMorgan reserve expenses, the portion of those loans that were approved for repurchase fell to 2.2 percent by September 2008, according to the complaint.

Proof that the bank ignored a third-party review is “major, that’s hugely newsworthy,” said Isaac Gradman, a San Francisco- based consultant and formerly a lawyer at Howard Rice Nemerovski Canady Falk & Rabkin.

With the Syncora loans, “if they’re making an argument out of one side of their mouth and a different argument out of the other, that is arguably a breach of an implied covenant of good faith and would be very strong evidence to prove repurchase demands,” he said in a telephone interview. Gradman represented mortgage insurer PMI Group Inc. in a now-settled lawsuit over similar issues against General Electric Co. and its defunct mortgage unit.

Potential Double Standard II: Accepting money or other consideration from the lender that sold the mortgage on the basis of defects or early non-performance and not forwarding this immediately to the trust holding the mortgage. The working assumption here was that the investors would be made whole by the firm insuring the deal.

Ambac also alleges in its proposed complaint that, as early as 2005, Bear Stearns was making a strategy out of earning “double” money on shoddy mortgages. First Bear Stearns sold securities backed by the debt, then forced the mortgage lender that sold it the loans to pay up when they turned delinquent in the first few months or were otherwise proved to have breached originators’ representations, Ambac said.

Bear Stearns generally wouldn’t refund investors with that second pool of money, Ambac said in the filing.

While such so-called early payment defaults may not require repurchases of mortgages out of securities by the issuers of the bonds, because of differences between securitization contracts and those entered into by lenders, Bear Stearns’s policy raised questions at the time, according to the complaint.

External auditor PricewaterhouseCoopers LLP advised Bear Stearns in August 2006 that it needed to review loans that were defaulting or defective to see if their quality breached its obligations and begin the “immediate processing of the buy-out if there is a clear breach in order to match common industry practices, the expectation of investors and to comply” with its mortgage bonds’ contracts, according to the amended complaint.

Its own lawyers by early 2007 were making similar suggestions, according to the complaint.

By the end of 2005, Bear Stearns had moved to making sure to securitize home loans before their early payment default periods ended, without informing investors and insurers of the switch, according to the complaint.

Then, if the loans went delinquent or were otherwise found defective, the company would seek settlements from lenders, rather than repurchases, which would have required the cash paid by originators to flow through to the securitization trusts so the debt could be passed back, according to the complaint.

“That is how we pay for the lights,” one employee told another in an Aug. 11, 2005, e-mail cited in Ambac’s filing.

In 2007 and the first quarter of 2008, Bear Stearns resolved repurchase claims to lenders on more than $1.3 billion of mortgages through settlements or for other consideration, according to the complaint, which cited the deposition of an employee. The securities firm received more than $367 million of “economic value,” according to the complaint.

The case is Ambac v. EMC Mortgage, 08-cv-9464, U.S. District Court, Southern District ofNew York (Manhattan).

Current loan-level performance information on an observable event basis would greatly reduce, if not eliminate the ability of a Bear, Stearns/JPMorgan to act in the manner alleged in the complaint.

If the investors know how the mortgages are currently performing, they can reject bad mortgages before they ever become a part of the deal.

If the investors know how the mortgages are currently performing, they would also know if the lender that sold the mortgage was repurchasing or otherwise making a settlement payment on the mortgage. This would allow the investor to make sure the proceeds were forwarded to the trust. At a minimum, investors and insurers would know that there was far less collateral in the trust.

At a minimum, the allegations in this case raise the standard of due diligence that must be done by European credit institutions under Article 122a before they can invest in a private label RMBS deal. It is hard to claim to know what you own if the mortgages in the collateral pool have already been put back to the lender under a settlement.

Monday, January 24, 2011

More details have emerged about Spain's plans to bailout their savings banks (cajas). As reported in the Telegraph,

Finance minister Elena Salgado said capital injections into the cajas would “in no way exceed €20bn [£17bn]”, with a large part coming from the private sector. Spanish banks will have to boost their core Tier 1 capital ratio to 8pc, even stricter than the Basel III rules.

As discussed in previous posts, in the absence of current loan-level data, why would investors believe that this is enough capital to make the cajas solvent?

Investors have seen Ireland up the ante three times on the bad loans in their banking system and still need a bailout. Why should they believe that Spain is any different? The article clearly indicates that they do not.

“This is unlikely to be a game-changer, and could potentially unwind the relief rally we have seen in the markets,” said Silvio Peruzzo, RBS’s Europe economist.

“We view €50bn as the minimum recapitalisation for the Spanish banking system that would restore investors’ confidence,” said the bank.

The RBS economist thinks that 2.5X more capital is needed than does the Spanish government. Clearly, there are parallels between the Irish and Spanish real estate bubbles. In Ireland, house prices have dropped to 2002 levels. Could this be factored into his estimate of capital needs?

RBS said Spain remains caught in a vice of tightening fiscal policy and a deepening property slump that may culminate in a 40pc fall in house prices, eroding the solvency of the cajas. The Madrid consultants RR de Acuna estimate the overhang of unsold homes at 1.2m.

Mr Peruzzo called on EU leaders to take much bolder action to overcome the crisis, demonstrating that they really mean to “save Spain” by beefing up the rescue machinery. EU ministers played for time at a key meeting last week, giving an impression of complacency.

... RBS said there is a risk that new proposals in the pipeline will not be “forceful enough” to mark a turning point in the eurozone drama. It said Spain “will remain exposed to contagion”, unless the EU takes pre-emptive action.

Goldman Sachs takes a rosier view, deeming Spain to be fundamentally “solvent”. It estimates further caja losses at €15bn. Even if Spain slips into a double-dip recession this year under a “pessimistic scenario”, public debt will peak below 90pc of GDP. Exports are recovering, with car shipments at record highs.

Analysts are split over the true state of the cajas. Arturo de Frias at Evolution Securities said parts of Spain’s banking system look “Irish”. The “problem ratio” on €439bn of property debt may reach 60pc. “We calculate a worst case of €142bn future impairments – €59bn for banks, and €83bn for the Cajas,” he said.

Brussels clearly fears that Spain is still at risk. Olli Rehn, the EU’s economics commissioner, called for urgent action to beef up the rescue fund (EFSF) before the next spasm of debt jitters. “We need to agree as quickly as possible. The recent lull in market tensions gives us breathing room, but we can’t sit back: we must act now with full determination,” he told Die Welt.

The bottom line is that the Spanish government is committing itself to only slightly more in recapitalization funds than the most optimistic projection of need.

By denying that the need for capital could be substantially higher, the Spanish government is betting its credibility with the capital markets. If reality is closer to the RBS projection, Spain will be scrambling to fill the hole in its banking system at a time that it has zero credibility with the capital markets.

Last Friday, Sir John Vickers provided an overview of what changes in structure and capital might be required of UK banks. This overview does a wonderful job of framing the issues and potential solutions that global regulators are struggling with in trying to prevent another credit crisis.

... With the Independent Commission on Banking approaching the halfway point in its work, now is a good time to take stock of some issues concerning how to regulate the capital and corporate structures of banks.

... recommendations will be directed at three broad aims: to reduce the probability and impact of systemic financial crises in the future; to maintain the efficient flow of credit to the real economy and the ability of households and businesses to manage their risks and financial needs over time; to preserve the functioning of the payments system and guaranteed capital certainty and liquidity for ordinary savers.

... [The question] is whether, and if so how, structural reforms might relate to other reform initiatives, especially those to enhance banks’ capital structures and the credibility of their recovery and resolution plans to cope with crises.

The scale of the problem

One of the roles of financial institutions and markets is efficiently to manage risks. Their failure to do so and indeed to amplify rather than absorb shocks from the economy at large has been spectacular. The shock from the fall in property prices, even from their inflated levels of a few years ago, should not have caused havoc on anything like the scale experienced. Rather than suffering a ‘perfect storm’, we had severe weather that exposed a damagingly rickety structure.

Your humble blogger disagrees with the conclusion.

As regular readers know, it was the failure of regulators to evolve in their application of the FDR Framework that was the basis for the credit crisis. The FDR Framework has two roles for regulators: insure that all market participants have access to useful, relevant information in an appropriate, timely manner; and refrain from endorsing specific investments.

What the credit crisis showed was that regulators needed to adopt 21st century information technology so that current asset-level data would be available for both financial institutions and structured finance securities. Then, market participants would not have to guess what is on the balance sheet of financial institutions or a structured finance security, but instead could focus on valuing the financial institution or structured finance security based on what is on the balance sheet.

If the diagnosis is wrong, other than luck, why should any of the regulatory proposed cures prevent the next credit crisis?

Hence the magnitude of the questions being addressed internationally of how to regulate the capital and corporate structures of banks (and other institutions) so that the system is properly resilient in the future.

...we have been asked for views, one way or the other, on possible structural reforms, including forms of separation between retail and investment banking.

Retail and investment banking

By ‘retail’ I mean not just payment services and deposit facilities, but also activities such as mortgages and SME lending. By ’investment’ I mean wholesale and investment banking services including lending and operational services to large corporates as well as trading and other capital markets-related activities. Both sorts of banking are risky, both are important, and in places the boundaries between them are fuzzy. But the policy challenges for retail and investment banking are somewhat different.

For the most part, retail customers have no effective alternatives to their banks for vital financial services, and hence there is an overriding economic, social and political imperative to avert any disruption to the continuous provision of those services. The task is to find better ways of ensuring this, if possible while allowing unsuccessful individual institutions to fail (safely).

Customers of investment banking services, on the other hand, generally have greater choice and capacity to look after themselves. But it is vital to find ways for the providers of these services to fail safely – a point underlined by the mess of the Lehman bankruptcy. Markets for investment banking services are also more international, as must be policy towards them. By contrast national policies, including competition policies, can bear more directly on retail markets, which tend to be national in scope.

Banking in wider context

Banking, including retail banking, is always going to have risks, and there will be ‘maturity transformation’ so that savers can get access to funds at shorter notice than it is lent to borrowers. It must also be kept in mind that attempts to minimise risks in one part of the system can shift them elsewhere; perhaps to a safer place, perhaps not. Ultimately, financial risks have to be borne, and in a market system they should not be borne by the taxpayer providing a generous safety net.

An important element of bearing risk is the ability to price the risk.

If there is not adequate data available to analyze and price the risk, as demonstrated by the credit crisis, markets are going to need the taxpayer safety net. If there is adequate data available to analyze and price the risk, then markets should do a good job of having risk borne by those participants who are safest to hold it.

Risk externalities and policy credibility

As to the risks posed by banks, an economic perspective in terms of externalities may be a useful starting point. Not for the first time in history, banks and borrowers in the last decade took risks that went bad systemically and imposed huge costs on the rest of the economy and society. The consequences for credit flows and possibly even the payments system and ordinary bank deposits would have been unimaginably worse but for government rescues. It would therefore not be credible for governments to say that they would not intervene to save retail banking services (in the broad sense indicated earlier) in future crises.

The result is two kinds of distortion to banks’ risk-taking incentives. First, whether or not they perceived themselves as having enjoyed it pre-crisis, and subject to the soundness of public finances, systemically-important institutions now have an implicit state guarantee for risk-taking activities, particularly those related to and/or inseparable from retail banking. This distortion, which is also a distortion to competition with other institutions, should be neutralized or contained.

Second, banks should be discouraged from taking risks that increase the probability and severity of systemic crisis externalities in the first place. Those externalities would seem to be most acute in relation to retail banking services because of the imperative of continuous provision, but apply also to other services unless there are safe resolution mechanisms for them.

This is the case for market discipline. A requirement of market discipline is that market participants have access to useful, relevant data in a timely manner. Market participants analyze this data and adjust the pricing at which they will offer funds to a bank based on its risks. The riskier the bank, the higher its cost of funds.

Textbook approaches to negative externality problems are taxes and quotas. Capital and liquidity requirements on banks have elements of both. Like taxes, they have (private) costs, and like quotas they constrain the amount of risk-taking (relative to the capital base). Moreover, their purpose is not only to curb incentives to undertake the externality-generating activity, but also to stop the negative spillovers by absorbing them. Alas the loss-absorptive capacity of bank balance sheets proved to be poor in the crisis.

Brittle bank balance sheets

The growth in bank leverage in the run-up to the crisis was explosive. From the 1960s until a decade ago, UK bank leverage was around 20 times on average. But from 2000 it rose sharply, to 30 times and beyond on average, and in some case much more.

This increased the fragility of bank balance sheets and, when the crisis hit, they turned out to be weaker still. For example, a number of supposedly ‘off balance sheet’ entities leapt onto bank balance sheets once they got into trouble. In the good times the banks enjoyed the regulatory arbitrage benefits of the formal structures they had created; in the bad times a mix of financial, legal and reputational linkages often dissolved formal distinctions as banks felt they had to absorb ‘off balance sheet’ losses if they could.

But the capacity of their liability structures, beyond equity, to absorb losses was poor. Balance sheets often proved brittle. While some subordinated debt-holders took losses, senior debt-holders generally came out whole as taxpayers rode, or were ridden, to the rescue. In theory, losses are borne sequentially by equity-holders and then debt-holders by inverse order of seniority, with retail depositors compensated to the extent provided for by deposit insurance schemes. In practice, and despite the state of public finances, fear of the consequences of senior debt-holders coming out less-than-whole forced taxpayers to jump the queue of loss-absorbency.

Whether or not taxpayers end up losing money in the process, they were compelled to shield senior debt-holders for fear of what would happen if they did not, which is not how things should be. Since mid-2007, then, we have gone from a position where insured retail depositors in UK banks were expected to take a 10% haircut to one where all senior debt-holders are de facto fully covered, at least in systemic crises if the public finances can bear it.

Can the potential loss-absorbency of bank debt credibly be restored? It might be a useful first step to make insured retail deposits senior to, rather than on a par with, other senior debt-holders, in the creditor pecking order, but that would not itself be enough.

The restoration of the loss-absorbency of bank debt requires that investors know they are not buying unrecognized losses on the bank's balance sheet. Again, this means that current asset-level data must be disclosed so that investors can know what they are buying.

Today, investors do not know what they are buying with bank debt. Currently, regulators are allowing banks to extend loans and pretend that they are performing. The combination of no data and extend and pretend is a barrier to restoring bank debt's loss-absorbency.

Contingent capital

A case can be made, in the light of what has happened, that equity is the only really credible loss-absorbing buffer between banks and the state. But, in good part for the tax reason mentioned earlier, equity is expensive (for private interests but much less so socially) relative to debt. Moreover, equity holders may be especially reluctant to issue fresh equity when, as in times of stress, much of the benefit accrues to bondholders; the debt overhang problem. Hence the attraction, at least in theory, of contingent capital that converts debt into equity if and when signs of stress appear. The conversion trigger might be automatic for example dependent on some observed capital ratio or subject to the constrained discretion of the regulatory authorities. Neither is straightforward, however.

Potential problems with automatic conversion are that the triggering conditions are lagging, or otherwise somewhat arbitrary, indicators of the need for more equity, or else that they are manipulable by speculative market traders. On the other hand, discretionary triggers may run into problems of price uncertainty, regulatory capture by vested interests, and/or time inconsistency (e.g. reluctance to activate the trigger when the time comes). The system-wide dynamic effects of conversions at times of emerging systemic stress might also be unpredictable. There appears to be a wide variety of views on whether such problems can be solved, and hence on the potential role of contingent capital on banks’ balance sheets.

The real problem with contingent capital is if there is no current asset-level disclosure. Without it, how would an investor know if they are buying existing losses? Current asset-level disclosure is necessary if market participants are going to be able to evaluate the risk of and price contingent capital.

Barclay's recently announced that it would use contingent capital to pay bonuses. This makes sense, as the holders of the contingent capital are employees with at least some access to current asset-level data.

So how to increase loss-absorbing capacity?

If, then, one takes the view that the loss-absorbing capacity of banks needs to be massively enhanced and beyond the prospective requirements of Basel III in the case of systemically-important institutions there are dilemmas about how best to achieve that. Senior debt has generally been poor at absorbing losses (but junior debt less so). Equity is good at it, but (privately) somewhat more expensive, in part because of unintended consequences of the general corporate tax system. And while contingent capital may in theory combine the advantages of debt and equity, there are serious questions about how well it would work in practice. We would welcome further views and analysis on all these points.

The alternative to increasing the loss-absorbing capacity of banks is to reduce the risk of banks so that it is in line with current debt and equity loss-absorbing capacity. As discussed earlier, this is the role of market discipline.

Asset risk

The ability of banks to absorb losses needs to be assessed relative to the riskiness of their assets. Capital regulation seeks to address this by way of risk weights. Some versions of ’narrow banking’ would eliminate most risk by requiring deposits to be fully backed by government bonds. But that would shift lending – including to personal and SME customers – elsewhere, and it is very doubtful that the implicit government guarantee would be confined to narrow banking. What sort of institutions would have loans on their books under narrow banking? Maybe mutual funds – a kind of mass securitisation. But to ban the funding of ordinary credit by deposits could have considerable economic cost.

While the ICB is unlikely to favour radical forms of narrow or limited purpose banking, their aims deserve recognition. In particular, they seek by structural reform and much higher capital and/or liquidity requirements to limit (or make redundant) the government guarantee of risky activities, so that they can be left to the market. Second, they note the useful risk-bearing role that non-banks can play. As we have seen, however, depending on their linkages with banks both directly and through pro-cyclical market effects non- (or shadow) banks can amplify, as well as absorb, risks to the core banking system.

The discussion lays out a continuum for linking capital to asset risk. On one end is capital regulation by means of risk weights. Using risk weights results in capital being a small percent of the risky assets. On the other end is funding all assets with 100% capital.

Current asset-level disclosure brings a different way of linking capital to asset risk. It makes it possible for the market to price the risk of the bank.

How corporate structure might matter

A theme in the discussion so far has been that the failure of retail banking services credit provision as well as payments system and deposit-taking services would be especially damaging in terms of wider economic and social costs. Retail (including SME) customers are more dependent on their banks than larger corporate customers, and perceived jeopardy to the continuous provision of those services, particularly by major retail banks, would not only have serious effects on economic growth but could also cause widespread panic amongst the public, notwithstanding deposit insurance schemes.

One response to this concern could be somehow to ring-fence the retail banking activities of systemically-important institutions and require them to be capitalized on a stand-alone basis. A variant of this idea would be to require the ring-fenced retail banking activities to be relatively strongly capitalized, while adopting a lighter regulatory policy towards the other activities (if any) of banks, thereby focussing (and limiting) the need for heightened capital requirements on the key retail services. Such ideas meet objections, however, both about practicability (especially if adopted without international agreement) and desirability. Questions about practicability are for another day. What about desirability?

Is retail banking safer with universal banks?

One of the arguments made in favour of universal banking is that it allows diversification of risks with the result that the probability of bank failure is lower than if retail and investment banking are in some way separated.

The credit crisis showed that the benefit of diversification can be overwhelmed if banks take on too much risk.

To examine the logic of this claim, consider a stylised example in which a universal bank U has two operations: retail bank R and investment bank I and compare its failure probability with those of the two banks if they are separated. Assume to begin with that the same business strategies are pursued in each case and that there are no synergies. Then a necessary condition for U to fail is that R or I fails, but this is not a sufficient condition unless R and I both fail if either does. So, in this simple setting, the probability of U failing is lower than that of a failure in the separated regime.

It does not follow, however, that retail bank failure is less likely with universal banking. In this respect universal banking has the advantage that a sufficiently profitable or well-capitalized investment banking operation may be able to cover losses in retail banking. But it has the disadvantage that unsuccessful investment banking may bring down the universal bank including the retail bank. In shorthand, in this simple setting, retail banking is safer with universal banking than with separated banking if and only if the probability that I saves R exceeds the probability that I sinks R.

An important question about forms of combination of retail and investment banking is how this balance of probabilities can be shifted favourably, both within institutions and systemically.

Current asset-level disclosure is the key to shifting the balance of probabilities favourably both within institutions and systemically. As discussed earlier, market discipline limits risk in banks. One of the great sources of market discipline in the banking industry will be other banks who have an incentive to properly price and limit the amount of credit extended to the riskiest banks.

Markets have to have data if they are going to properly assess and price risk.

A challenge for separation proposals is to guard against risks that problems with investment (and shadow) banking could anyway threaten the continuity of retail banking through financial, legal and/or reputational (including ‘confidence’) connections. Developing safe ways for providers of investment banking services to fail therefore matters not only because of the importance of those services but also because of the risk of collateral damage to retail banking.

Of course the probabilities of failure are not all that matter. Impact of failure is also critical. Depending on the surrounding circumstances, the negative impact of U failing could be greater than the sum of the impacts of R and I failing individually, especially if they are less likely to fail at the same time.

Moral hazard and the efficient use of capital

As to the simplifying but false assumption of constant business strategies and no synergies, several points are worth making. First, there is the moral hazard concern that the investment banking arm of U effectively has a state guarantee that standalone I may not, so that without countervailing measures (e.g. extra capital requirements) it will have incentives to take on more risk.

Second, in assessing potential synergies, it is essential to distinguish real (‘social’) efficiencies from private gains that come directly or indirectly at others’ expense. For example, access to taxpayer-subsidized capital is a private gain but not a real efficiency; indeed it is a distortion.

Third, the largest synergies claimed for universal banking relate to the efficient use of capital and funding, although there may also be synergies on the operational side. But in this regard it seems quite hard to identify and quantify real efficiencies as distinct from purely private gains. There may be some social benefits of diversification that cannot otherwise be achieved, but to the extent that the ‘more efficient’ use of capital involves risks being run with less capital, there are implications for default probabilities.

Another point in relation to capital efficiency is that with separated capital pots, sub-optimal capital allocation across types of lending may result. However, market economies appear well able to allocate capital and other resources other than by corporate integration.

We would especially welcome further analysis of questions such as these concerning the efficient use of capital, and how it might be affected by alternative ways of regulating the capital and corporate structures of banks.

Credible resolution plans

Complementary to moves towards stronger capital and liquidity to reduce the probability of failure are policy initiatives to contain the fall-out if failure occurs (or approaches). Because normal bankruptcy procedures work so badly for large, complex and interconnected banks, it is imperative to develop credible recovery plans and resolution tools. Much work is under way in the UK and internationally to tackle this problem. The resolvability of global investment banking operations is a particular challenge, and of heightened importance to the UK given the scale of bank balance sheets relative to GDP.

An important question is whether, and if so how, structural reforms could help this reform programme. Credible resolution would seem to require at least some form of separability, and arguably there is a case for some form of ex ante separation so that bank operations whose continuous provision is truly critical to the functioning of the economy can clearly be easily and rapidly carved out in the event of calamity. But perhaps the credibility of resolution plans can be ensured otherwise than by forms of separation, and the benefits of creating such options would of course need to be weighed carefully against costs they imposed.

Conclusion

This talk has contained more questions than answers, as is appropriate at this stage of the ICB’s work. Let me conclude by way of two general questions and one observation about relationships between structural reform possibilities and other banking reform initiatives.

It cannot be disputed that banks of systemic importance need much more loss-absorbing capacity than they had a few years ago, and to be much more easily resolvable. There is a wide range of views on how much more loss-absorbing capacity is appropriate for different kinds of institution, and on how to achieve it by equity, contingent capital, etc.

Including current asset-level disclosure!

The first general question is whether, and if so how, structural reform of systemically-important institutions might affect appropriate levels of loss-absorbing capacity. If the probability and/or impact of bank failure particularly of retail service provision can be reduced by forms of separation between banking activities, then so too might capital requirements. If so, the case for structural reform might be greater the higher is the cost of bank capital.

The second general question is whether, and if so how, forms of structural separation might enhance the credibility and effectiveness of resolution schemes.

The observation is that, if forms of separation were thought desirable in terms of public policy, there would be the further question of whether they should be required of the institutions concerned, or incentivized, for example by appropriately different capital requirements for different business models. Riskier structures need deeper foundations.

These and other issues will be central to the ICB’s agenda in the coming months.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.